Trader’s Narrative

Here’s an interesting chart from Merrill Lunch’s recent “Hedge Fund Monitor” report. It shows that traditional long short hedge funds have returned to a historically normal market exposure after the shock late last year:

With the end of the year barreling closer, hedge funds, like any other money manager out there wants to coast to an easy finish and hang on to their gains to be able to bank their lucrative incentive fees. One safe strategy is to sell their long positions and replace them with calls to have the best of both worlds.

This may explain one of the only places where we’re seeing some cautionary signs of exuberance. In last week’s sentiment overview I mentioned that the options pits is showing an awful lot of calls being bought relative to puts. While I’m hesitant to outright dismiss any irksome metric, some of that can be explained away by the penchant to lock in gains via calls. However, not all of it can be attributed to portfolio managers trying to coast to large Christmas bonus. That’s because the ISE sentiment which exclusively measures retail option traders is showing similar indications of exuberance.

Another interesting tidbit from the ML report is that hedge funds have on average reduced their exposure to ‘high quality’ stocks since April 2009. That makes sense since retreating into safer issues is a tried and true strategy in times of distress. Right now though, more speculative equities are getting most of the love. And that’s exactly what we’re seeing in the breadth measures as almost every single Nasdaq and NYSE stock participates in the rally.

You can download the whole Merrill Lynch report from the FREE trading resource section (check in the Reports & Articles folder).

A quick summary of all things sentiment-wise for the stock market this past week:

Sentiment Surveys
The mind set of the retail investors as measured by the weekly AAII sentiment survey shows little change. We had an increase of 7% points for the bearish camp to 46% and a decline of 6% points for the bulls to 33%. Which is not very helpful as it leaves us mired in “no man’s land” - exactly where we’ve been for the past few months.

In contrast, the Investors Intelligence weekly survey of newsletter editors continues to be dominated by optimism. This week we had a small reduction in the bullish camp to 44.8% and a small increase in the bearish camp to 26.4%.

Bond Bears
For what is happening in terms of sentiment in bonds, check out the post from a few days ago: bond sentiment.

Options Sentiment
CBOE put call equity ratio: We got a slight ‘blip’ on Thursday (June 17th 2009) when this ratio hit 0.88. That’s not even close to a level which would get any contrarian excited. But it is the highest level of fear shown in this indicator since early March 2009. Keep in mind though that this trusty indicator has been firing blanks throughout this bear market.

ISEE Sentiment index: the equity only call put option ratio from the ISE reached a low this week we haven’t seen since November 2008. Remember, this is inverse to the usual put call ratio so a large number denotes optimism and a low number fear. On Thursday the ISEE Sentiment index reached 92 (meaning 92 calls purchased for every 100 puts purchased to open a retail options position).

This dovetails with the technical indicators that are also showing a very short term oversold condition in the market. The key is how the market reacts as a result: will it use it to bounce strongly higher? or collapse lower in spite of it?

Secondary Market
The doors of the IPO market have been shut tight for many months now. And although we are seeing the door budge open again slightly, the real action has been in the secondary market.

According to TrimTabs, last month saw a record shattering $64 billion dollars of IPO and secondary market offerings combined. To put that in perspective the previous monthly record was just $38 billion. While TrimTabs didn’t provide a sector breakdown, I suspect that most if not the vast majority of the record issuance was in the financial sector.

Historically, there is an inverse relationship between the primary and secondary market activity and forward market performance. This isn’t surprising since at the heart of the market, once you remove all the noise, is a simple supply and demand equation. There are a finite number of dollars chasing a finite number of shares. If you tip the balance in one direction, the market will react eventually.

According to two methods of analysis (from TrimTabs and Ned Davis Research) we are seeing a historical extreme that has only been seen before quite rarely. For more details, check out this article by Mark Hulbert. My only criticism of this analysis is that they use nominal numbers instead of ratios.

Since the market generally rises over time (recent history excluded), it isn’t helpful to compare the secondary market in say 1998 in dollar terms to that of today. The way we can equalize it is to look at the ratio of the secondary market to the total market (for example, the total equity value of the S&P 500). In this way we can easily compare across decades and get a more accurate idea.

This criticism notwithstanding, since the other extreme readings come from relatively recent years (2000, 2008, etc.) we can conclude that a ratio analysis would yield little improvement. The conclusion stands that Wall Street is suddenly awash in ‘paper’. I’m sure some will come up with conspiracy theories of this spring rally being rigged to allow for the recapitalization of the ailing US banks. But remember what Ben Graham said about the stock market: “In the short run it’s a voting machine, but in the long run it’s a weighing machine.”

Here’s this week’s sentiment overview chock full of sentimental goodness. Enjoy:

AAII
This week’s AAII sentiment survey moved the bulls and bears in different directions, albeit both by the same 2 percentage points. The bulls move up slightly to 24% and the bears fell slightly to 55%. Looking at the ratio of bulls and bears, we’re back to levels that we last saw in mid-July 2008 - not that it did the market much good back then. While it shows some real concern by the retail investor, it still doesn’t show extreme levels of fear. As well, the slight amelioration doesn’t bode well because when the survey was taken, the market was still at support.

Investors Intelligence
The newsletter editors, as measured by ChartCraft’s weekly sentiment indicator are 28.6% bullish and 45.1% bearish. That’s a move in the right direction but not enough to give any contrarian a reason for pause. The last time we saw real fear was late last year when there were the bullish camp was as small as ~20% and the bears more than half.

Conference Board Consumer Confidence
The Conference Board Consumer Confidence Index was released this week and it wasn’t pretty. We hit another low when it fell again to 25.0 - in fact, all three measures (including present situation and expectations) fell again. Consumers that described business conditions are “bad” rose to 51.1%. There was also a jump in people’s expectations of job losses - 47.3% from 36.9%.

Barron’s Confidence Index
Richard Russell introduced me to this lesser known indicator. It is a ratio of the high grade bond index and the intermediate bond index. Since it measures stress in the bond market, you won’t be surprised to learn that during this latest bear market it has fallen to an unprecedented degree. In November 2008 it fell to 45 and the latest weekly data is 51.6. To put that in perspective, during the end of the last bear market the Barron’s Confidence Index made a sloppy double bottom in the 65-70 range. A You can keep track of it online at Barron’s website or by leafing through the Market Lab section of the printed edition.

ISEE Sentiment
The call-put ratio known as the ISEE sentiment index actually went up on Friday, as the S&P 500 broke down to levels not seen since December 1996. I prefer to look at the equity only data for the ISE because it strips out the index and ETF trades. While not extremely high, the fact that it increased to 157 is a conundrum. It means that on average, the retail options trader on the ISE opened 157 calls for every 100 puts.

At first I thought that perhaps the fact that breadth has been favorable would account for this. While the large cap stocks fall, dragging the indices with them, more and more mid to small cap stocks are not making new lows. So perhaps the options data would suggest that option traders are betting on non-large cap stocks. But on the other hand, stocks have to meet certain criteria to have options and for the most part, those are larger capitalization stocks.

OEX Option Sentiment
The S&P 100 index put call option ratio is once again at a bullish extreme. Two weeks ago I mentioned that the OEX options sentiment was sliding to levels which have previously been interpreted as very bullish. This week, they continued to fall, registering the lowest daily ratio in about 25 years. While normally this would be wildly bullish, there are two problems with this.

One, the number of contracts traded in this specialized options market has been steadily eroding and it has reached a very small number. So small that it is questionable if the data holds any real value. Second, recent extremes haven’t really yielded any actionable consequences for the market. While more and more bulls pile in buying OEX calls relative to puts, the market continues to slide.

Nova Ursa Rydex Ratio
The Rydex family of funds were the first precursors to the ETF smorgasbord that we have today. Although pushed further to the periphery with each leveraged ETF, they are still around and command a significant chunk of funds under management. The Nova Ursa ratio measures how bullish or bearish the Rydex investors are feeling at any moment. The Rydex Nova returns 150% of the S&P 500 daily returns while the Ursa fund (now known as Inverse) attempts to return the opposite returns generated by the S&P 500 index.

The current level of bullishness - as measured by how much money is dedicated to Nova vs. total funds in Nova and Ursa - is at a decade low. To find a lower ratio, you’d have to go back to late 1995. The next lowest level after that was late last year (November 2008) and previous to that early 2003. This has been a wonderful signal in the past. Two things could dampen its power: one, similar to the OEX options sentiment, the level of participation in Rydex funds has waned as people move to ETFs and leveraged ETFs. Second, back in the early 1990’s we saw the extreme readings pile up in stacks, week after week, throughout 1994, until the S&P 500 index took off like a rocket in early 1995.

Here is the sentiment overview for the last week of the month (in terms of returns, the worst January ever!):

AAII
The American Association of Individual Investors’ weekly sentiment survey had 47% of respondents bearish and only 25% bullish. That may seem like good odds for a rally… except that we’ve been hereabouts before (in late 2008) and yet the market weakness continued.

Investor’s Intelligence
This week’s II sentiment survey shows the bears at 38% and the bulls at 34.8%. This is a continued amelioration of the exuberance that we’ve seen for the past several weeks, but it still leaves the two camps, more or less, equal to one another.

Fund Flows
Yesterday we talked about the lack of IPOs which are in a sense, supply of “paper” to the market. On the other side stands the fund flows which measure the demand for equities through the purchase or sale of mutual funds.

Not surprisingly, mutual funds have undergone a scorched earth scenario where for more than a year, we’ve hardly seen net inflows:

Source: Data by AMG Data and chart by SentimenTrader.com

Although this data has a contrarian tinge to it, there is nothing bullish about seeing a continuous erosion of mutual fund flows. A sudden and sharp decline is far different than what we are seeing now. Eventually, for the market to be able to find its legs again and push forward, we will need to see people willing to pour billions and billions of dollars into new mutual fund purchases.

Options Sentiment
Neither the CBOE put call ratio or the ISEE call put sentiment ratio are significantly different from last week’s sentiment overview.

From recent option sentiment readings we have reason to believe that after a fantastic “Santa Claus rally” the market is entering thin air territory - at least in the short term. To that we can add an important technical indicator: the McClellan Oscillator.

If you’re unfamiliar with it, it is simply a measure of underlying breadth and is calculated by taking the difference of advancing and declining issues and then using this net breadth to calculate 39 day and 19 day exponential moving averages. The oscillator is then calculated by subtracting the former by the latter.

You can calculate this oscillator for any market and for each it will display different characteristics but usually, +100 is considered overbought and -100 oversold.

Here is the McClellan Oscillator for the NYSE:

I would take this chart with a grain of salt because over the years, a larger and larger portion of the issues traded on the NYSE is attributed to non-common stock securities like bonds, CEFs, municipal bond funds, preferreds, etc. But even so, the McClellan Oscillator is off the charts!

And this is the McClellan Oscillator for the Nasdaq:

It is important to note that this technical indicator compliments the view that option traders provide because they are both short to medium term in nature. It wouldn’t make much sense using a long term indicator, like say, the Coppock Curve to confirm a short term indicator - or vice versa.